The case involves a large condominium construction project involving several contractors. The lender was a licensed real estate broker that facilitated the raising of construction loan funds for the project. The owner of the project borrowed $13,625,000 from the lender to fund the remaining construction of the project. The lender agreed that it acted as a construction lender for purposes of the California “stop notice” statutory scheme.

Under the terms of the owner’s loan, the lender was obligated to obtain $2.8 million to close the transaction and agreed to use its best efforts to raise the balance of the loan in stages. The lender obtained the initial funds and distributed them to the owner. The lender, as it raised funds for subsequent stages of construction, assigned portions of its beneficial interest in the construction loan trust deed to third-party investors.

The lender entered into private loan servicing agreements with its third-party investors, under which the lender served as each investor’s agent with regard to the construction loan. The lender paid the third-party investors interest on their fractional loan interest and charged a servicing fee. Under the private loan placement and fee agreements on each of the loans, the lender prepaid itself interest, loan fee/points, loan underwriting and other fees totaling $1,555,771.37. The loan servicing agreements between the lender and the third-party investors were not recorded as public record. The lender contributed some of its own money to fund the construction loan, resulting in a small beneficial interest in the construction loan trust deed and promissory note. The lender raised and disbursed a total of $12,018,612.50 and never funded the remaining balance of the loan amount.

The Court summarized the California “stop notice’ procedure as follows:

After giving a 20-day preliminary notice, a laborer or materialman may serve a stop notice upon the owner or the construction lender. A timely served stop notice obligates the owner or lender to withhold funds for the benefit of the stop notice claimant. Once a stop notice is timely served on an owner or lender, an action to enforce the stop notice must be commenced within 90 days of the deadline to serve the stop notice, regardless of whether the stop notice was served early.

The party whom received the timely stop notice is required to withhold funds in the amount of the stop notice until the expiration of the claimant's deadline to file an action to enforce the stop notice, plus five additional days for receipt of a notice of commencement of the action to enforce the stop notice. If several stop notices have been filed and not enough money exists to pay them all, stop notice claimants share pro rata in the available funds. If a lender fails to withhold funds required by the bonded stop notice, it is personally liable to the claimant for the full amount of the claim.

A stop notice claimant obtains priority over any "assignment" of the construction loan funds, whether the assignment is made before or after a stop notice is served.

The dispute involved 4 specific contractors. One of the contractors served its bonded stop notice in June, 2007 when the lender was holding sufficient unexpended construction loan funds to cover the claim. The lender, however, did not withhold sufficient funds to satisfy the claims and the parties agreed that the lender had stop notice liability as to that contractor. By October 2007, the lender had fully disbursed all monies in the construction loan. The lender received additional bonded stop notices from the other 3 contractors in March and April 2008, by which time all construction loan funds held by the lender had been disbursed.

All of the contractors filed actions against the lender and others. The sole issue before the trial court was the lender’s liability with respect to the contractors’ bonded stop notice claims. The contractors argued that the lender was prohibited from assignment of the construction loan funds, before or after receipt of a stop notice, and that under Familian Corp. v. Imperial Bank (1989) 213 Cal.App.3d 681, the lender could not avoid a stop notice claimant’s priority by private agreement.

The trial court awarded the contractors a total of $1,555,771.37, which was apportioned among them, plus costs, prejudgment interest and attorneys’ fees under the stop notice statute. The trial court also denied the lender’s motion for entry of judgment against two of the contractors based on those contractors’ alleged failure to comply with the stop notice statutes.

On appeal, the Court of Appeal recognized that Familian was a case of first impression, but that it unequivocally established that a secured lender could not defeat a stop notice claimant’s statutory priority to construction loan proceeds by segregating the fund into pre-allocated accounts and thereafter deducting charges and interest as accrued. Under Familian, the lender’s pre-allocation of funds to pay points, interest and other non-construction costs, like the lender had in this case, constituted an “assignment” of the construction loan funds within the meaning of the stop notice statutory provisions that was subordinate to the perfected claims of contractors. The Familian court further realized that limiting a stop notice claimant’s priority to “unexpended or “undisbursed” loan funds would render the stop notice statutory provisions meaningless because the lenders would then simply arrange to deduct their profits at the inception of the loan to assure a double recovery at the expense of the contractors responsible for enhancing the value of the property.

The Court of Appeal rejected the lender’s attempt to overturn Familian or otherwise distinguish it in such a way to render it inapplicable to the facts of this case. The Court of Appeal was clear: “the Legislature created the stop notice law to give laborers and materialmen priority over lenders to payments from the construction loan fund.” The Court of Appeal also clarified that Familian did not invalidate the pre-allocation of construction loan funds by lenders. Instead, according the Court, lenders were free to draft construction loan agreements to give themselves a contractual right to priority but those agreements will cede to a stop notice claimant’s statutory priority.

The Court rejected the lender’s argument that a “super-priority” first trust deed wiped out the lender’s priority and, as a result, it was not unjustly enriched by the stop notice claimant’s contribution to the project. The Court concluded that the holdings from Familian did not attempt to avoid unjust enrichment and did not depend on whether the lender ultimately realized a gain or loss on the project. The Court established that the stop notice claims took priority over any monies the lender received from the construction loan funds.

In addition, the Court of Appeal provisionally reversed the trial court as to one contractor and remanded the matter to resolve a factual issue. As to that contractor, the Court concluded that because it was not the prime or general contractor, it was required to provide the 20-day notice under the stop claim statute. It was undisputed that the contractor had not provided the required notice. The contractor asserted, however, that it was exempt under the statute because it had a direct contract with the owner, and had commenced work on the project before the lender recorded its construction loan trust deed. The Court remanded the matter to the trial court on this potentially dispositive factual issue.

Finally, the Court addressed the issue of one of the contractor’s failure to give the lender a required notice of the commencement of the stop notice action. According to the Court, by the time the contractor served its bonded stop notice the lender did not have any undisbursed funds left in its control. Thus, the contractor’s failure to give the lender notice of the commencement of the action did not prejudice the lender because the lender had no funds to release. The Court held that the contractor’s failure to strictly comply with the stop notice statute was excused where there was no prejudice to the lender.

In sum, the Court affirmed that the lender was required to honor the stop notice claims, even in the presence of a private agreement that allowed the owner to segregate and pre-allocate funds to be used for deducting charges and interest as accrued to the lender. In addition, the Court held that there was a question of fact as to whether the recognized exemption for contractors with direct contract with the owner applied here. Finally, the Court held that a contractor’s failure to strictly comply with the stop notice statute was excused where there was no prejudice to the lender.

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